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Competitive labour markets

The demand for labour - marginal productivity

The demand for factors of production is
derived from the demand for
the products these factors make. For example, if mobile phones are in greater
demand, then the demand for workers in the mobile phone industry will
increase, ceteris paribus.

The demand for labour will vary inversely with the
wage rate. To understand this we need to consider the law of diminishing
returns. This states that if a firm employs more of a variable factor,
such as labour, assuming one factor remains fixed, the additional return
to extra workers will begin to diminish. To explore this process, we
need to consider the total physical product (output) produced by a
series of workers, which will enable us to measure the individual output
from each additional worker – the marginal physical product (MPP).

Consider the following data for a small firm
producing handmade wax candles.

Workers

Total physical product

Marginal physical product

1

1000

2

1900

900

3

2700

800

4

3400

700

5

4000

600

6

4500

500

7

4900

400

8

5200

300

Demand is based on the value to the firm of the marginal physical product produced by each
worker. For example, if candles are £2 each, the firm can calculate the
revenue derived from each worker's physical output. The value of the extra output is called
marginal revenue
product (MRP), and this is calculated by multiplying MPP and price, as follows:

Workers

Total
physical product

Marginal
physical product

Marginal revenue product

1

1000

2

1900

900

1800

3

2700

800

1600

4

3400

700

1400

5

4000

600

1200

6

4500

500

1000

7

4900

400

800

8

5200

300

600

Deriving a demand curve

We can now find the number of workers that would be
employed by a profit maximising firm at various wage rates. The profit
maximising firm will employ workers up the point where the marginal
benefit, in terms of the MRP, equals the marginal cost of labour (MCL), which
in this case is the wage rate (W).

For example, at a wage rate of £1,200, the firm will
employ 5 workers, because at 5 workers, MRP = MCL. At a lower wage of
£800, the firm will employ 7 workers, and so on. This
means that a demand curve can be derived. In labour market theory, the
demand for labour is identified as MRP=D.

The supply curve of labour in a competitive market

In a perfectly competitive labour market, where the
wage rate is determined in the industry, rather than by the individual
firm, each firm is a wage taker. This means that the actual equilibrium wage will be
set in the market, and the supply of labour to the individual firm is
perfectly elastic at the market rate.

Equilibrium wage in the
labour market, and supply for the individual firm.

The simple model of market wage

The competitive market wage rate, and the quantity
of labour employed, is determined by the interaction of demand and
supply. The equilibrium wage rate is the rate that equates demand and
supply, as illustrated below.

Equilibrium wage rate

Labour supply for the whole market is assumed to be positively
related to the wage rate, and the market supply curve slopes upwards.

Changes in market wage

Market wage may change following a change in an
underlying condition of demand or supply.

Demand can change, and the demand curve will shift,
under a number of circumstances, including changes in:

The productivity of labour.

The price of the product.

Demand for the product.

Shifts in the demand for labour

Labour supply can change under a number of
circumstances, including changes in:

The length of the working week.

Participation rates.

Demographic factors, such as migration, and
changes in the age structure of the population.